The effect of the recession has highlighted how much retail owners and purchasers have relied upon steady or annually improving rents, cash flows and projections. Perhaps it’s not possible to completely prepare for a change in future market conditions, but not adapting to them when making financial decisions can crush cash flow. This two-part blog article will discuss dangerous assumptions involved with retail acquisitions in a recessionary environment.

Triple Net Investment Grade Leases

One of the most unpleasant retail surprise has been with triple net investment-grade long-term leases (henceforth investment-grade leases). Many tenants that everyone expected to remain financially sound and last forever have downsized, renegotiated their leases or gone out of business. When demand declined and an oversupply situation arose, the value of investment-grade leases declined for two reasons. First, market rent declined, leaving many leases with contract rent greater than market rent. Investment-grade lease tenants, whether stand-alone or an anchor in a shopping center, are savvy enough to know they’re in the much better negotiation position. Every lease can be broken and they know it. The result has been what the banking industry refers to as a “cram down”, – for retail tenants, landlords needed to drop their contract rents closer to market or else the tenant walks.

Many landlords also feel the financial pressure from the recession and litigating a long-term lease against a usually publicly traded national tenant is more expensive than renegotiating the lease rate. If the anchor is part of a shopping center, having one or more dark anchors usually results in lost in-line bay tenants, in-line bay tenant renegotiation, the owner absorbing the common area maintenance charges of the anchor(s) and a better negotiating position for the remaining anchor(s). Owners know this and so do their anchor tenants. The results are many reasons to renegotiate the investment-grade lease.

Valuing Investment-Grade Leases

In addition to the drop in market rent, the increase in the vacancy and collection loss for large retail properties throughout the country has resulted in a decline in the market value of investment-grade leases. Even if contract rent is not renegotiated, higher market vacancy and collection losses are required for many investment-grade leases, which lowers net operating income and therefore value.

More importantly, the capitalization rate (the fraction that gets divided into net operating income to produce a value estimate) goes up, usually by a considerable amount. Why? First, the probability that the lease rate will be renegotiated lower is much greater in a recession. Second, there’s the possibility that the investment-grade lease tenant will file bankruptcy. If that happens, it’s notoriously easy for the court to cancel a lease. Third, in most markets, retail hubs have shifted to other areas as the result of large super-regional mall construction or retail sub-markets that were created in the last ten years, pulling tenants to those newer, larger markets (a basic application of the retail attraction theory) and away from older markets. All these factors result in higher capitalization rates and therefore lower investment-grade lease values.

Modernization

Many shopping centers are in need of modernization; however, the recession has siphoned funds to do so from many owners. The whole purpose of renovating a shopping center is to make it more competitive and to increase rental rates. When few or no competitors are renovating, there is little need to renovate to become more so. More importantly, rental rates will not increase as long as the recession continues to plague the cash flow of retail tenants. Basing a purchase decision on an expensive shopping center renovation is not a wise investment decision, especially when the debt service from renovating will be added to the debt service from the acquisition.

Although a prudent purchaser or owner would calculate the return on investment (ROI) of renovating a shopping center, seldom do they calculate the return on the renovation or all the costs associated with their expectations. Basic expected value theory is a useful technique to use to calculate the ROI. By taking the income from the tenants to be brought to the center due to the renovation, multiplying each income stream by the probability of attracting the tenant and adding them, the expected rental income is derived. Applying the same technique to the additional common area maintenance reimbursements, increases in rental rates for existing tenants (likely none, as discussed below) and all incomes, the result is the expected income the center will receive. The same can be done for the expenses of obtaining these tenants (leasing commissions, tenant improvements if any, etc.). Some costs will be incurred regardless of how many new tenants will be added as a result of the renovation: an example is additional regional or national advertising. These costs do not get a probability multiplied by them.

Adding all the incomes and expenses above results in an expected net operating income from the renovation.   Of course, renovating the shopping center might also help maintain rent levels and tenants; if an estimate can be made as to what the rent loss would be to renegotiate, that too can be included in the income calculation above. It then becomes easy to calculate the ROI for the renovation. We have done this many times and it is rare that it results in a sufficient return to justify the cost to do so. Most shopping center owners do mental variant on the above and know that it is not financially feasible to renovate a center during a difficult recession.

New Management and Filling Large Amounts of Vacant Space

Lofty expectations for attracting new tenants to a shopping center are a recipe for disaster. The market dynamics that affect a center remain the same, so the effect of changing management and filling vacancies is limited. Most times the expectations for new tenants are based on attracting national tenants, but there are two problems with this. Frequently many of the expected national tenants were already located at the center and left or they already considered it and dismissed it altogether. Unless the dynamics of the retail market change substantially for the better, they won’t relocate there now or in the future. Also, national tenants have sophisticated methods for evaluating a center and a market, so if the dynamics are not within their parameters they will not be interested. If they’re not already there and the market is still the same, expecting to get them is myopic.

Increasing Rents and Tenant Talk

Expecting to simply acquire a center and raise rents is another disaster waiting to happen. When a center has materially lower rates than its direct competitors, it’s easy to compare the two and assume that rents can be increased. This overlooks the fundamental weaknesses in the market or the property. There’s a reason the center is renting for less and unless the owner or purchaser of the center understands this, no amount of rent raises will be accepted by the tenants. This has been tried too often without success. All it does is alienate tenants, creating a hostile environment.

Tenants in a mall tend to talk to one another and lease rates are a favorite topic. When a center takes on temporary tenants, long-term lease tenants frequently find out how low the rates are from them and their knowledge is power. Raising rents when there are temporary tenants in a shopping center is a strategy doomed to failure.

Conclusion

Many prospective purchasers of malls have expectations that do not coincide with market realities. Financial analyses are performed based on lofty expectations for change and although the ROI might appear attractive, the probability of them happening can be a very different matter entirely. Most of the time the realities are brought to the forefront when a third-party is hired to perform a market study, such as an appraiser. By then, a lot of money and time has been invested and unfortunately wasted. This can be avoided by having a market study or reposition study performed before tens of thousands of dollars are spent on non-refundable deposits, renovation plans, title investigations, Phase 1 environmental site assessments and the many other due diligence requirements to make transactions happen.

John Simpson, MAI